| Summary: | Both developed and emerging markets have liberalised their stock markets by removing investment restrictions on equity capital inflows and outflows. The aim is to attract foreign investors and also to allow domestic investors to diversify internationally. However, existing literature shows that local investors overweight the domestic market (home bias), whilst foreign investors under or overweight foreign markets (foreign bias). Current studies have mainly investigated factors that determine home and foreign bias. The study uses comprehensive macro and micro level data to examine the implications of home and foreign bias on three research questions. The first empirical study investigates the impact of home and foreign bias on cost of capital. We mainly use five measures to proxy for cost of capital. We find compelling evidence supporting the hypothesis, those countries that exhibit higher home bias, experience higher cost of capital. Similarly, consistent with theory, we find that countries that have higher foreign bias enjoy lower cost of capital. In the second empirical study, we examine the impact of home and foreign bias on stock market development. Economic reasoning suggests, that countries that have home bias should have lower level of stock market development, while the countries where foreign equity portfolio investors invest more, should be associated with higher development. Our findings, based on rigorous analysis, confirm that prevalence of higher degree of home bias impedes stock market development. Likewise, higher foreign bias in equity portfolio allocations has significant positive implications for the development level of domestic stock market. Finally, in our third empirical research, we examine whether varying degrees of home and foreign bias have any impact on country level investor protection standards. We report two findings. First, we find strong evidence that supports the hypothesis that home bias leads to weak investor protection. Second, consistent with theory, countries that experience higher foreign bias, tend to have better investor protection. The findings suggest that provision of encouraging optimal international portfolio allocations to increase risk sharing, could be a crucial policy measure for governments. Policy makers in emerging countries can improve macroeconomic fundamentals and good governance to attract and retain foreign investors.
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